John Plender writes an interesting piece discussing the possibility that banks cannot innovate without dramatically increasing risk, and loss.
Galbraith is quoted as relating all banking innovation to role of debt.
Originative Sin – the future of banking | Financial Times
Sceptics highlight obvious costs. Galbraith, in A Short History Of Financial Euphoria (source of the earlier quotation) emphasised the pervasive role of debt: “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets . . . All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”
And Andrew Hilton of Centre for the Study of Financial Innovation, a London-based think-tank, argues:
that “you can make the case that banking is the only industry where there is too much innovation, not too little”.
There is much discussion of ABCP of all types, including derivatives, CDO, CDS, sub-prime mortgages etc.
There is also the role of regulation, and how banks use innovation to guard against regulation.
A more fundamental explanation of why innovation can be counterproductive reflects a desire to escape the heavy hand of the state. Merton Miller, the late Nobel laureate, declared in a 1986 paper that “the major impulses to successful financial innovations have come from regulations and taxes”.
If that makes innovation sound subversive, regulatory arbitrage (locating a trading business in a place that has the laxest local laws) can nonetheless have economic and social benefits if directed at bad policy. The US in the 1970s, for example, responded to rising inflation by reviving a Depression-era measure called Regulation Q, which put a cap on deposit interest rates in the hope that by keeping banks’ cost of funds down, mortgage loans would be less expensive.
Then finally there is the counter-intuitive role of regulation, and the law of unintended consequences. The introduction of Basel 1 & 2 while designed with the notion of ensuring banks were better capitlaised, actually had the opposite effect in two marked ways:-
- a flawed definition of capital (tier 1 and 2)
- a shift to off balance sheet debt not adequately captured by Basel.
Measures of leverage based on Basel’s “tier one” capital ratio, which were the main focus of analyst attention, appeared less frightening than those based on conventional accounting, which revealed a more disturbing picture that went largely unobserved. The outcome was that banks ended up more highly leveraged than most hedge funds. Nothing illustrates better how the law of unintended consequences can contribute to financial blow-ups.
[Note: this is why more regulation is not necessarily better; elimination and redefinition might be better]
Relevance to Bankwatch:
As the article rightly points out, innovation is not restricted to debt, and can involve internet, cards, and other technology, all of which can serve customers better and reduce costs.
However the main message I took from this article is that banks are battening down the hatches, and little innovation will be seen from most in 2009. What a perfect oportunity for some bank to develop customer innovation, that does not increase risk, but does serve customers better.
Bankwatch 